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Fonterra’s capital structure proposals are the biggest since its formation in 2001. The devil is in the detail, says Keith Woodford

Fonterra’s capital structure proposals are the biggest since its formation in 2001. The devil is in the detail, says Keith Woodford

Fonterra’s latest proposals to change its capital structure will be far reaching.

If implemented, they will essentially undo the misleadingly named ‘Trading Among Farmers’ (TAF) system set up in 2012. I say ‘misleading’ because in reality that was a scheme of trading between farmers and non-farmer unit investors. But the proposed changes do not stop there.

The second part of Fonterra’s proposal is to allow Fonterra’s shareholder farmers to hold as little as one share for every four kg of Milksolids (the ‘capital M’ as sometimes used by the industry reflects that it is actually fat plus protein and ignores other solids) that are supplied, or as much as four shares for every kg of these supplied Milksolids.  The full implications of that will be profound, although not all are identified within Fonterra’s proposal booklet. 

Taken together, these will be the biggest changes to Fonterra’s structure since it was formed back in 2001. But first I will deal with each of the two elements separately.

The Reversal of TAF

The TAF system was brought in to reduce the perceived redemption risk. This was the risk that if Fonterra lost a significant number of suppliers, then under the old co-operative structure they would not be able to pay out the departing members for their shares. It was also stated, including by directors although generally when speaking off-the record, that it was about shifting the balance-sheet risk away from the co-operative and passing it to the farmers themselves.

The way that the system was engineered to achieve this has been that the shares of departing farmers would be shuffled across to the newly formed Fonterra Shareholders Fund which in reality was mainly for non-farmer investors who would purchase non-voting equities called investment ‘units’. The size of that fund would fluctuate, not only with fluctuations in the price of the units, but by two-way movement between units and farmer-held shares.

This two-way flow of units and shares meant that the price of shares and units would always be very similar, within a cent or two. This thereby created a value for Fonterra’s shares determined by the market rather than administratively by Fonterra itself.

TAF was a very clever system with considerable complexity. One of the consequences of this was that it became challenging to communicate the limitations of the systems in simple terms. Those of us who tried to point out those limitations were essentially smothered by the Fonterra public relations machine, combined with dominant leadership within Fonterra itself both at Board and CEO level.

To clarify that last point a little further, although Theo Spierings was the CEO when TAF was finally implemented, the scheme was largely developed by the time he arrived. In any case, TAF was very much a policy decision and hence it was the Board and not the management that had to take overall responsibility.

Nine years later, with a totally different Board, there is a recognition that TAF does not actually remove the redemption risk.

Here, I now return to that fundamental flaw in the thinking behind TAF. The flaw was that the only way TAF could remove the redemption risk should Fonterra lose a major number of suppliers was by taking on a new risk of losing control of the company to non-farmer investors.

That risk was always obvious. So why did Fonterra take nine years to come to that conclusion?

One key reason for the change in thinking is that farmers have now told Fonterra very clearly that it is imperative for the sake of their own farming businesses that farmers remain in control of Fonterra. The logic of that is very clear. Farmers are correct in their thinking. 

Ironically, this was also how farmers felt at the time that TAF was implemented. The difference then was that the proponents of TAF kept beating away over a three-year period and eventually overwhelmed the opposition to TAF and its predecessor proposals.

At the time TAF was implemented, Fonterra saw the main risk as coming from new entrants to the industry. These were companies such as Synlait and Miraka, plus Open Country which was in expansion mode.  That source of risk is much less right now.

The new source of risk that Fonterra perceives is that regulatory and perhaps market factors might lead to an overall decline in the size of the dairy industry.  Fonterra states this with carefully chosen words, but their thinking is clear. Fonterra wants to front-foot the risk and get its house in order for supply decreasing by perhaps 10% or 20%.  The specific figures are mine not theirs. Ten percent would be manageable under the current structure but 20% would not be manageable. They want to be proactive rather than reactive.

If Fonterra’s thinking about redemption risk is correct, then TAF has to go.  That means that the ‘Fund’ as Fonterra now refers to it must either be dismantled or capped at its present size. The preference is that it be dismantled but that can only happen if 75% of the unitholders agree.

This will mean offering investors a price well above the current price of those units. Therefore, there has to also be an alternative should unitholders not agree and hence the possibility of a fund that is capped to its present size in terms of the number of units.

Before moving on to the second part of Fonterra’s proposal, I need to make one point very clearly. TAF was never about providing significant new capital. It was always about removing or at least reducing redemption risk. Fonterra made that clear many times, but this is something that commentators often failed to recognise.

Changing the Share Standard

If the unitholder fund is to be dismantled, then the key question that has to be addressed is how can Fonterra then deal with leakage of funds from the balance sheet should milk supply decline?

Fonterra recognises that it does not itself want to purchase these shares from departing farmers. The solution is to invite other Fonterra farmers to buy the shares as investment shares at up to four times the standard; that is, up to four shares for each kg of Milksolids that they produce. 

Fonterra also feels pressure from its members to allow lower shareholdings than the current one share per kg Milksolids. So, the idea here is that the minimum shareholding in future should be only one share per four kg Milksolids.

Comparing the proposed new maximum and minimum farmer shareholdings relative to their milk supply gives a ratio of 16:1.   That creates a massive mis-alignment of interest between some shareholders and others. Some shareholders will want to have the dividend maximised and others will want the milk pay-out maximised. This is something that Fonterra has not made explicit. Yet this tension between dividend and milk pay-out is the fundamental reason why farmers do not want to lose control to non-farmer investors.

The effects on share and unit values

Should the Fonterra proposals be implemented, then even if the Fund remains in a capped form there will no longer be alignment in price between the shares and the units. Indeed, that alignment will disappear as soon as the market re-opens on 7 May, given the pipeline between the two funds will be non-operative from that day.

I am writing this while the overall market for Fonterra shares and units remains closed. But my expectation is that there could be an immediate increase in the price of units.  Investors will recognise that Fonterra will have to offer a premium to buy them out.

In the longer term, there is a considerable risk that the shares held by farmers may decline in price. This is because there could be a loss of market liquidity. More farmers will want to release some capital by selling than there will be farmers wanting to buy.  Fonterra recognises that this is a possibility.

What Fonterra has not acknowledged is that banks will now place a higher risk weighting on Fonterra’s shares in farmer balance sheets.

An alternative pathway

All that I have written above are my initial thoughts. What I have not addressed is an alternative pathway for Fonterra, given the acknowledgement from Fonterra that the current system does not manage redemption risk.

I am intrigued as to what the best pathway forward might now be. The challenge is that it is not easy to unscramble an egg that was cooked nine years go. What a great pity that Fonterra was so arrogant back in those times.


*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. His previous articles can be found at https://keithwoodford.wordpress.com You can contact him directly here.

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21 Comments

Hi Keith,thanks for writing a well researched & documented article on the new capital structure proposal.It is indeed interesting now Fonterra now believe that farmers now should be the only investors in the co-op.At one of the meetings pre TAF,I asked that very question why we could not fund these dry shares (units) within the co-op ourselves ,the answer from the directors was that farmers probably wouldn't have the appetite for the amount of capital required for the size of the fund.My question is what has changed since then- do the directors think that by allowing farmers to only require 1 share per 4kg milk solids,that we will reinvest all that share capital & more to pay out unit holders at a premium price?

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Joe,
One thing that has changed is that Fonterra is now much less ambitious about conquering the international dairy world. I think Fonterra still has some international assets to sell which could go towards buying out the Fund. But I also tend to the perspective that there are lots of unintended consequences to identify with what they are proposing.
KeithW

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So..... will we sell shares to reduce bank debt further or buy more shares to back our well run co-op or sell shares to pay more for dairy land???????
Least we are now starting to get some options...........

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Depends what the Bank says.

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The potential 16:1 disparity is a sobering risk. I wholeheartedly agree with your last sentence.

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Small farmers could find themselves at the mercy of the big boys very quickly. Never short a horse named Self-interest

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Perhaps a change in voting rights from a share basis to a per farm basis.
Couldn't agree more on that last sentence. A pity many attribute all the problems to Theo when in fact there were many others over a longer period.

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I like the concept of one vote per shareholder. I would have thought it is more aligned to all shareholders belonging to the cooperative for the same reason, less devisive, more conducive to long term stability.

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I don't see the need for wholesale change. Think of the current set up as A and B class shares with different voting rights. When held by a suppliers 1 share = 1 vote, when owned by Joe Public 1 share = 0 votes. You could address the barriers to entry and facilitate succession planning by reducing the holding requirements and removing the cap on the size of the fund.

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The problem occurs if Fonterra loses a significant number of farmers. With the current system, those shares will end up in the investor Fund (the FSF). At that point the unitholders will demand a say in running the company. Also, currently there is a constitutional limit on how big the Fund can grow and that raises the question of what happens then. But as long as Fonterra does not lose supply then there is no problem.
KeithW

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Could this be a way to hide dealings with China????
There is beginning to be a lot more scrutiny on slave labor, human rights etc. demanded of public companies and supply chains.
Fonterra would become a private co-op again.
Usually more to the story.
Has been a crap investment for shareholders anyway.

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bjr8,
I don't think this has anything directly to do with China, but there is no doubt that China is crucial to the future of all our primary industries. If China did stop buying, then the impact would be on farmers more than Fonterra itself. This is because the way the system works, Fonterra clips the ticket for processing the milk at a price that is independent of what it sells for in the market place.
KeithW

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I was suggesting it could be a way for Fonterra and the dairy farmers to avoid public scrutiny by not having public shares. A private co-op could be easier to fly under the radar.

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Hi Keith. One issue you did not cover that is a real problem with the current TAF operation is the way Fonterra farmer supplier shares are valued. The control has been removed from farmers and given to corporate investors. The requirement to redeem dry shares to units has meant that the unit price (and units only account for 6-7% of capital involved) determined the share price. The tail has been wagging the dog. Witness some large institutional investors buying into the fund and driving all our shares higher and then later exiting and dropping the share price. Our share price has become disconnected from our reward of payout and more reflective of the relative return on investment to shares and bank deposits. In a more 'normal' company share price would reflect a combination of income and asset backing where Fonterra has become a pure dividend play.

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Wilco,
I agree that it has been the units that have determined the overall price of Fonterra shares. That was intentional in TAF as supposedly the 'unit market' would know how to price the units, with this flowing through to the shares.
If the proposals are passed, then it will be farmers who are pricing the shares. It should work OK as long as Fonterra does not lose supply. But it gets tricky if too many farmers decide to depart unless there are some big corporate farmers who wish to invest in shares. The financial engineers who designed TAF understood that. When I used the term 'clever' to describe TAF I meant it in the context that the financial engineers were indeed smart people and I mean that in a nice way. They came up with a scheme that met the needs of their masters on the Board.
Currently I am leaning to the perspective that there are likely to be considerable unintended consequences. My gut feeling is that once the Board thinks all of this through then the proposals might get significantly amended.
Keith

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An update: The immediate market response has been highly negative with the units dropping 8.7 % as at 1.30pm and the shares dropping 13.3%, albeit on low turnover in the case of the shares. Given that this is just a proposal, I don't think Fonterra would have seen that coming. It is the first of the unexpected consequences.
KeithW

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Bit late this week but I'm actually tempted.
First time I've even thought about showing support in fonterra.

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The reason Fonterra wants to get rid of the FSF units is because they know that the way the dividend is calculated breaks all ethical guidelines and possibly legal ones as well.
The split between the farm gate milk price and the dividend is calculated based on a formula and audited to give an appearance of integrity, whereas it is anything but fair to share and unit holders.
This is because the milk price assumes in its calculation that Fonterra is an efficient producer with a competitive cost structure, but of course it is not.
Which in turn means the milk price is based on theoretical costs and these are lower than the actual cost, and the difference between the two lowers the dividend by the same amount.
While I see this is necessary - if real costs were used the Fonterra milk price would be lower and its competitors would rapidly increase market share - the end result is that as milk volumes decrease Fonterra becomes less efficient (economies of scale) and the dividend will eventually disappear and unit holders will be furious once they work out what is really happening and dumbfounded the dividend disappears even when the value add business performs well.
I assume the aim of this major structural flaw was that over time Fonterra would become more efficient and the problem would sort itself out, but the actual outcome was that Fonterra and Nathan Guy in 2013 decided to double volumes by 2025 as a means of diluting the inefficiencies. Instead of becoming more efficient they gambled on building newer plants and reducing the overhead cost per kgMS.
Now this will come back to haunt them as the untrammelled growth met a backlash due to the unacceptable environmental consequences and volumes will have to decrease which means the inefficiencies increase and the dividend decreases.
Fonterra has cannabalised itself with a flawed strategy under Theo ably assisted by National.

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And yet twice they've taken from the milk price to pay a dividend.
Lower volume means more value added as a proportion of the total with added ability to shift where needed.
I'm impressed they can pay a dividend with such a high milk price and seemingly have room to maneuver on this capital rejig, it's so far removed from where they were. Some smaller companies aren't feeling so secure.

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The fact they have had to reduce the milk price to pay a dividend just proves how screwed up the model is. And the amounts were so small as to be insignificant.
Another fact. Farmers don't care about the dividend. The milk price is what counts.
Lower volume means commodity prices will rise, and as those are a cost to the value added business, then the dividend will fall. I think what you are trying to say is lower volumes allow Fonterra to optimise the commodity product mix, so they can produce more cheddar or butter as prices fluctuate, as they are not hampered by capacity constraints.
That is correct but nothing to do with the dividend from the value add side of the business. The commodity prices will rise which means the dividend falls.
You might be impressed by the fact they can pay a dividend, but again, the return on capital of the value add business is pathetic.
People don't understand how the farm gate milk price is artificial and the sole purpose of this is to drive off competition, and this constrains the ability of Fonterra to add value, pay a good dividend and return an acceptable ROI.
Most farmers don't understand this, let alone FSF unit holders.

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Sounds simple enough to me. Non farming investors want to extract all value at the expense of the cost of milk.
To achieve an acceptable roi, they just need to manage and invest capital wisely.

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